What Is Deferred Bid-Ask Spread?
The Deferred Bid-Ask Spread refers to the nuanced difference between the immediately quoted bid and ask prices for a financial instrument and the actual spread realized by a market participant over a short period, often due to market dynamics unfolding after an order is placed. It highlights how the true Transaction Costs associated with trading can deviate from the initially visible Liquidity indicator, influenced by factors such as Trading Latency and the rapid evolution of market information. This concept falls under the broader field of Market Microstructure, which examines the process by which securities are traded and how various factors affect prices and trading costs in Financial Markets.
A Market Maker continuously quotes a bid price (what they are willing to pay) and an ask price (what they are willing to sell for). The spread between these two prices compensates the market maker for providing liquidity and bearing certain risks. However, in fast-moving electronic markets, the price at which a trade is executed can differ from the quoted price at the moment an order is initiated. This "deferred" aspect of the bid-ask spread captures this dynamic reality, where the immediate quote may not fully reflect the ultimate cost or benefit due to delays in execution or subsequent price movements.
History and Origin
The concept of the bid-ask spread itself is as old as organized markets, representing the compensation for liquidity provision. Historically, market makers, also known as specialists or dealers, quoted prices manually, and the spread reflected their compensation for handling order flow, managing inventory, and facing Information Asymmetry. Early academic models, such as those by Glosten and Milgrom (1985), formally demonstrated how a bid-ask spread would exist even in the absence of Order Processing Costs or Inventory Costs, primarily due to the risk of trading with better-informed participants.6
With the advent of electronic trading and High-Frequency Trading (HFT) in the late 20th and early 21st centuries, the speed and complexity of order execution dramatically increased. This evolution made the distinction between the quoted spread and the realized or effective spread much more pronounced. Factors like Trading Latency became critical, as even tiny delays could lead to significant deviations between the price a trader expected and the Execution Price they received. The understanding of bid-ask spread components—including those related to order processing, inventory holding, and adverse selection—has continued to evolve with market changes.
##5 Key Takeaways
- The Deferred Bid-Ask Spread refers to the difference between a quoted spread and the actual spread experienced, influenced by factors that unfold over time.
- It is particularly relevant in fast-paced electronic markets where Trading Latency and rapid price changes can impact the final Execution Price.
- Understanding this deferred aspect helps market participants assess true Transaction Costs beyond initial quotes.
- Factors contributing to the deferred nature include Information Asymmetry, Order Processing Costs, and the market maker's Inventory Costs.
Interpreting the Deferred Bid-Ask Spread
Interpreting the Deferred Bid-Ask Spread involves analyzing the dynamic relationship between a market's stated liquidity and the actual costs incurred by market participants. It recognizes that in highly dynamic markets, the quoted bid-ask spread—the difference between the highest bid and lowest ask at a given instant—may not fully capture the complete cost or benefit of a trade. When an order is placed, especially a market order, there can be a delay before it is fully executed. During this delay, market conditions, including the underlying price and the prevailing bid-ask spread, can change.
A higher or more volatile Deferred Bid-Ask Spread implies that the market is either less liquid than its instantaneous quotes suggest, or there are significant risks like Information Asymmetry or high Trading Latency impacting trade execution. For instance, if a large order is placed, it might consume all available liquidity at the best prices, forcing the execution at less favorable prices within the Market Depth, effectively widening the realized spread beyond the initially displayed quote. This deviation is often referred to as Slippage.
Hypothetical Example
Consider an investor, Sarah, who wants to buy 100 shares of XYZ Corp. She sees the quoted price of XYZ Corp. as Bid $50.00 and Ask $50.02. The immediate bid-ask spread is $0.02. Sarah places a market order to buy at $50.02.
However, due to milliseconds of Trading Latency and ongoing market activity, by the time her order reaches the exchange's matching engine, a large sell order for XYZ Corp. comes in, pushing the ask price down to $50.01. Simultaneously, another buyer immediately antes up, raising the bid to $50.01. Sarah's order executes at $50.01, and the current quote becomes Bid $50.01 / Ask $50.03.
In this scenario, while Sarah initiated her trade at an apparent ask of $50.02, her actual Execution Price was $50.01. From her perspective, the initial $0.02 spread was "deferred" or adjusted by market conditions during the brief execution window. The effective cost of her transaction, relative to the immediate mid-price at the moment of execution, could be analyzed to understand this Deferred Bid-Ask Spread.
Practical Applications
The concept of the Deferred Bid-Ask Spread is critical in areas of quantitative finance, Algorithmic Trading, and risk management. For high-frequency trading firms, minimizing the impact of the Deferred Bid-Ask Spread is paramount, as their profitability often hinges on capturing minuscule price differences and executing trades rapidly. These firms invest heavily in technology to reduce Trading Latency and ensure their orders are among the first to arrive at exchanges, aiming to achieve the best possible Execution Price.
Market4 participants use analyses of the Deferred Bid-Ask Spread to evaluate the actual costs of trading across different venues and under varying market conditions. It helps in assessing the true cost of market access and the efficiency of order routing strategies. Regulators also consider market microstructure dynamics, including aspects related to how prices are formed and how spreads behave over time, to ensure Market Efficiency and fairness. Even the broader settlement cycle for securities, which introduces a time lag between trade execution and final ownership transfer, can be seen as a form of deferral in the overall transaction lifecycle, with recent moves to shorten it to T+1.
Lim3itations and Criticisms
A primary limitation of focusing solely on the quoted bid-ask spread is its static nature, failing to capture the dynamic forces that influence the actual cost of a trade. The notion of a Deferred Bid-Ask Spread attempts to address this, but it can be challenging to precisely quantify, as it depends on numerous variables including order size, prevailing market volatility, and the speed of information dissemination. While academic research has extensively decomposed the bid-ask spread into components like Order Processing Costs2